Low Cost Investing and Diversification with Index Funds

One of the best ways to get a diversified investment portfolio without a great deal of work is to invest in funds. Funds offer a collection of stocks in one investment. Invest in a fund, and you own a portion of each stock in that fund. It can be a simple way to enjoy the combined performance of several (or even hundreds or thousands) of stocks without going through the time-intensive process of picking stocks. And one of the easiest types of funds to invest in is the index fund. An index fund is inexpensive, usually diversified and simple to get started with. Additionally, index funds make great long-term investments for the buy and hold aficionado.

What is an index fund?

US Stock Indexes Source: Wikimedia Commons

Like a mutual fund, an index fund is a collection of the stocks of individual companies. However, an index fund tracks a stock index, commodity index, bond index or some other investment index, rather than being composed of stocks chosen by a manager of some sort. An index fund is composed of all of the stocks on a particular index. The most popular index funds usually involve tracking the S&P 500 index. Indeed, the first index fund — introduced by Vanguard — did just that. But there are other funds that track index performances:

Wilshire 5000, which tracks all publicly traded companies in the U.S.

Russell 2000, which tracks the companies with the smallest market cap.

Bond funds that follow the performances of aspects of the bond market.

There are, of course, numerous stock index choices, from those that track oil stocks to tech stocks, and including the ability to invest in funds that follow individual European and Asian stock indexes such as the FTSE 100, Stoxx 600, Nikkei 225 and the Hang Seng. It is even possible to find index tracking funds that are also exchange traded funds (ETFs), allowing you to more easily trade them on the stock market.

Using index funds in your investment portfolio

Index funds offer many advantages to a number of investors. They can provide diversity and relative stability to your investment portfolio over long periods of time. These funds have the advantage of being exceptionally low cost. Because they do not require the help of a manager, index funds often cost between 0.5% and 0.8%. This is much better than the average 1.5% to 2% that you pay for many actively managed mutual funds. When you use index tracking funds, you will find that you get to keep more of your money. It is also worth noting that many index funds are tax efficient. This means that they often manage to avoid realizing significant capital gains that an actively managed fund does. When combined with a retirement account, index mutual funds or ETFs become even more tax efficient.

Index funds are ideal for long-term, buy and hold investors because of their ability to do well over long periods of time. Since they track the stock market, they generally go up when your time frame extends out more than 10 to 15 years. Because, historically, the stock market always gains over the long haul, you are unlikely to lose out if you keep your money in index funds that track the stock market. There are some investors that compose their entire portfolios using index funds, adding foreign funds and commodity funds for a little more risk, and using bond funds as conservative investments. When you properly use index funds, asset allocation can become a little easier, allowing you to easily and precisely allocate your investments in different asset classes by choosing appropriate index funds and investing in them in the ratio that you desire. This takes away the guess work of figuring out which asset class a particular investment falls under. Your investments in each asset class will also be diversified as an additional bonus

You should note that many index funds require high minimum investments. This can make it somewhat difficult to get started with index fund investing. However, it is possible to find online investment accounts and work through other brokerages (almost everyone loves Vanguard) that have lower limits. In some cases, it is possible to avoid the minimum as long as you sign up to automatically invest from your checking account every month. Index ETFs offer the opportunity for you to track an index, but without the worry of minimums. Popular ETFs that track indexes include Spiders, Vipers and iShares.

If you are looking for more information on index funds, you can visit Morningstar.

1 Comment

Scott@stockmarketinvesting
on June 5, 2010 at 6:06 am

Index funds can be a great way to go and diversification is something every stock market investor should consider. As always, perform your due diligence before making any type of investment decision.

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